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Beyond the Border

Brazil: The First Financial Crisis of 1999
N JANUARY BRAZILthe eighth
largest economy in the world
devalued its currency, initiating the
first financial crisis of 1999. To understand Brazils crisis, it is useful
to examine the economic program
that preceded it.
In 1994, after years of failed price stabilization plans and resulting high inflation, Brazil initiated a stabilization plan
named for its new currency, the real.
Despite some problems, the Real Plan
was cause for optimism. Brazil took
steps to correct a large federal deficit,
reducing funds transferred by the federal government to the states and municipalities and increasing federal income
taxes. Monetary policy became more restrained. Finally, Brazil pegged its currency to the dollar. Pegging involved
using the central banks dollar reserves
to buy reais or using the real to buy dollars, whichever was necessary, to control the number of reais a dollar could
buy.1 In other words, if the free market
would not supply as many dollars as real
holders wanted at the official exchange
rate, then the government would supply dollars out of its reserves.
By pegging its currency, Brazil was
sending a signal not only about its currency but also about its monetary policy.
To effectively peg its currency to the
dollar, a country must follow a monetary policy parallel to that of the United
States. If Brazil were to peg to the dollar
and run a significantly more inflationary
monetary policy than the United States,
the difference between its inflation rate
and U.S. inflation would ultimately cause
intolerable stresses for its currency system; that is, U.S. prices expressed in
reais would become cheap to Brazilians, but Brazilian prices expressed in
dollars would be expensive to U.S. consumers. Everyone would buy American
and no one would buy Brazilian. Brazil
suspected it could not match U.S. monetary or inflation policy exactly, so it
maintained a crawling peg. This meant

Federal Reserve Bank of Dallas

the exchange rate would be allowed to

slide, but within limits.
The pegged exchange rate plus the
other aspects of the Real Plan did send
an important message to the world:
Brazil was making a persistent effort to
control inflation and was achieving its
goal. In 1994, the year the Real Plan
began, Brazils annual inflation rate exceeded 900 percent. By the end of 1998,
price movements were negative.
Despite the plans success, however,
the controlled devaluation built into
Brazils crawling peg was not enough to
offset the cumulative differences between U.S. and Brazilian inflation rates.
This overvaluation of the real made it
harder to sell Brazilian products abroad
because they were so expensive in dollars, and also motivated more Brazilians
to shop abroad.

Financial Contagion
Another event aggravated the fiscal
problems the country had hoped to
address with programs linked to the
Real Plan. Brazil began to suffer from
financial contagion, in part because of
worries about its overvaluation. Contagion occurs when a financial crisis in
one country motivates investors to remove their funds from otherperhaps

Chart 1

Brazilian Interest Rates

Percent
50

Korean crisis

Russian crisis

45
40
35
30
25
20
15
10
10/4/96 2/21/97 7/11/97 11/28/97 4/17/98 9/4/98 1/4/99

Chart 2

Fiscal Deficit Worsens

Percent of GDP
9
8

Total

Primary

Interest

7
6
5
4
3
2
1
0
1

1995

1996

1997

1998

similarcountries as well. When financial crises swept Asia in 1997 and Russia
in 1998, investors who were pulling their
investments out of those countries also
began to withdraw them from Brazil. To
discourage the outflow of dollars,
which the central bank would have to
supply to maintain the pegged exchange
rate, Brazil raised interest ratesa step
intended to entice investors to hold their
money in Brazil to earn high interest
rates. Chart 1 reveals Brazilian interest
rate surges, which reflect investor nervousness during the Korean and Russian
financial crises.
The large increases in Brazilian interest rates, however, were not enough to
keep foreign currency in the country.
To maintain its pegged exchange rate,
Brazil also had to devote much of its
foreign currency reserves to defend the
real. Dollar reserves, which had peaked
at more than $70 billion at the beginning of 1998, dropped by half that
amount by years end.
A growing fiscal deficit frightened investors. Chart 2 breaks down the deficit
between the portion attributed to interest
paymentsmarked interest and the
portionlabeled primary that is the
difference between government expenditures on goods and services and the
governments income from taxes and
fees. The primary deficit is not large on
Page 13

federal reserve

hwe
st

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onom

b a n k

o f

d a l l a s

Robert D. McTeer, Jr.

President and Chief Executive Officer
Helen E. Holcomb
First Vice President and Chief Operating Officer
Harvey Rosenblum
Senior Vice President and Director of Research
W. Michael Cox
Senior Vice President and Chief Economist

Senior Economists and

Assistant Vice Presidents
Stephen P. A. Brown, John V. Duca,
Robert W. Gilmer, Evan F. Koenig

Director, Center for Latin American

Economics, and Assistant Vice President
William C. Gruben

a year-to-year basis, but the year-in/

year-out accumulation of these deficits
by a country that has a history of debt
moratoriums can worry investorsespecially in the context of financial crises in
Asia and Russia. Nevertheless, even some
usual measures of overall indebtedness,
such as the debtgross domestic product (GDP) ratio, did not suggest an existing crisis.
While the primary deficit was not
large, the increases in interest rates
made the overall deficit much greater.
Last year, the two parts of the deficit
the primary and interest portions
summed to about 8 percent of GDP.
That, together with signs that the primary deficit problems might continue,
made investors nervous. Increasingly
uncomfortable with Brazilian debt in
any case, debtholders became particularly more reluctant to hold longer-term
Brazilian debt. The ratio of short-term to
total Brazilian debt increased markedly.

Senior Economist and Research Officer

Mine K. Ycel

Economists
Robert Formaini
David M. Gould
Joseph H. Haslag
Keith R. Phillips
Marci Rossell
Jason L. Saving

Fiona D. Sigalla
Lori L. Taylor
Lucinda Vargas
Alan D. Viard
Mark A. Wynne
Carlos E. J. M. Zarazaga

Research Associates
Professors Nathan S. Balke,
Thomas B. Fomby,
Gregory W. Huffman,
Southern Methodist University
Professor Finn E. Kydland,
Carnegie Mellon University
Professor Roy J. Ruffin,
University of Houston

Executive Editor
Harvey Rosenblum

Editors
W. Michael Cox, Mine K. Ycel

Publications Director
Kay Champagne

s
Copy Editor

Jennifer Afflerbach

Design & Production

Laura J. Bell

Southwest Economy is published six times annually by

the Federal Reserve Bank of Dallas. The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the
Federal Reserve System.
Articles may be reprinted on the condition that the
source is credited and a copy is provided to the Research Department of the Federal Reserve Bank of
Dallas.
Southwest Economy is available free of charge by writing the Public Affairs Department, Federal Reserve
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Page 14

The Endgame to Devaluation

As problems became more acute in
1998, some well-known economists
but not all of thembegan to call
openly for a Brazilian devaluation. After
the re-election of President Fernando
Henrique Cardoso last fall, hopes began
to rise that he could effectively address
Brazils budgetary difficulties. He announced a new budget plan to save
about $23 billion. Some analysts began
to forecast federal primary surpluses for
1999. A $41.5 billion International Monetary Fund (IMF) pre-emptive program
was announced to assure currency speculators that attacks on the real would not
be warranted.
Then hopes began to fade. In December, a deficit reduction bill was voted
down, in part by members of the presidents own coalition. A significant pension reform effort failed. Meanwhile, still
in December, the rate of capital outflows accelerated rapidly, to as much as
$350 million per day.
If a particular event could be said to
have triggered Brazils devaluation, it
was the announcement by the new governor of the Brazilian state of Minas
Gerais that he would suspend his states
debt payments to Brazils national government for three months. Capital out-

flows accelerated even more rapidly.

By mid-January, Brazil announced that
pegging was over and its exchange rate
would be allowed to float.

What Next?
What are the implications of Brazils
crisis for the United States, and for Texas
in particular? Although about 20 percent
of U.S. trade is with Latin America,
Brazil accounts for only about 2 percent
of total U.S. exports and 1 percent of
total imports. Similarly, Texas sends
only 2 percent of its total exports to
Brazil. For Texas, direct trade effects of
the crisis will be small. Brazils trade
links with Texas chief trading partners,
Canada and Mexico, are also extremely
limited.
Does this mean Brazil will have no
international impact? Weakness in Brazil
will have impacts on its chief trading
partners, of which Argentina is a primary example. But a broader concern is
that while Brazil had been subject to
contagion effects, it might now trigger
them. Although such effects were evident in some Latin American markets
immediately after the onset of Brazils
crisis, they appear to have subsided. For
now, the principal focus with respect to
Brazils problems is Brazil itself, where
the economy is already in recession. In
the wake of the devaluation and float,
Brazil began to approve fiscal reforms,
including much-needed pension reforms. Of particular interest will be the
new IMF agreement, debt negotiations
between state governors and the national government, and further congressional actions to address the central
governments fiscal deficit. All these factors will be significant as Brazil attempts
to resolve its crisis.

William C. Gruben
Sherry Kiser

Note

In Portuguese, the national language of Brazil, the plural form of

words ending in the letter l is typically is. Under this rule, because
one unit of Brazilian currency is a real, we refer to more than one
as reais.

Southwest Economy

March /April 1999